Taxable and Tax-Free Portfolio Allocation

A reader of this blog by the name of Jeff recently wrote a great comment that I felt warranted its own post.
Here’s his comment:

Hi Scott,

Great site !I stumbled across your blog in pursuit of dividend growth investing. Even though this post is from 2014, i’m still hoping you can shine some light into investing for dividends in taxable account.

A question I have is that by investing in taxable accounts, these dividends would be taxed at a max 20% every April, that means automatically from the get-go, we already lose 20% of the dividends’ values. I don’t know if there’s any way this can be avoided since if one were to max out Roth and traditional IRAs, the only place to park additional money is the taxable account. However, I’d still like to hear your thoughts:

1. How you prioritize investing in which type of assets in taxable accounts? ie, dividend paying stocks? REITs? Long term capital gain holdings?

2. How you optimize your portfolio in Taxable account? Do you replicate the same holdings as you do in your Roth IRA, that you buy also dividend paying companies?

Great questions! In fact, you brought up one of the main complaints with dividends: their taxation. The issue is that if a company pays dividends then they are distributing money that the company has already paid corporate taxes on. Then, when it shows up in our taxable accounts, we are taxed on it again. Double taxation!

The age old question is should companies retain that money within the company to invest in Research and Development, pay off debt, buy other companies, etc, etc, or should they distribute it to their shareholders?

As an individual investor it all comes down to what will make us the most money and do we want that money as capital gains or as income.

In a taxable account, capital gains would (only when sold) be subject to the same long term capital gains taxes that qualified dividends are exposed to. If we think that the compounding effects of investing free cash flow back into the company would do better than we could invest that money ourselves (after having paid the taxes on it), then we’d be advised to invest in companies that do not pay a dividend.

Should you eventually require income to live on, then in this scenario, you’d sell a portion of the portfolio to generate whatever income you need.

Likewise, if we feel we could do better reinvesting the dividends ourselves or need the income today, then investing in dividend paying companies would be wise.

1. How you prioritize investing in which type of assets in taxable accounts? ie, dividend paying stocks? REITs? Long term capital gain holdings?
The only steadfast rule that I use for choosing where to prioritize each type of asset has to do with REITs and a few select foreign stocks. Due to their unique tax structure, distributions from REITs are taxed at an ordinary income level, rather than the more favorable long term capital gains level of qualified dividends. For this reason, I have placed all REITs in my Roth IRA.

Another stock that I specifically chose to hold in a Roth IRA is the Royal Bank of Canada. The Canadian government withholds taxes from dividends paid by RY and other Canadian companies. Due to a tax treaty with the US, if RY is held in a tax-advantaged account, this withholding tax is not taken. However, if I were to hold RY in a taxable account, then the foreign taxes would be withheld. I could then claim the foreign tax on my own taxes and get that back as a credit. However, that would only occur once a year at tax time and I’d lose the (minimal) effects of compounding that foreign tax quarterly.

Ultimately, if there was no limit to how much money you could place in an IRA, then you’d want pretty much all stocks in it. Since the contribution amount is limited, then the common theory is that dividend paying stocks should be preferentially placed, allowing tax free reinvesting of the dividends.

2. How you optimize your portfolio in Taxable account? Do you replicate the same holdings as you do in your Roth IRA, that you buy also dividend paying companies?
Currently all the stocks I own in my Roth do pay dividends. Since I really like the concept of dividend growth investing, I am focusing a ton on dividend paying stocks. However, it is also in my taxable account where I have picked a few more risky companies that have the potential to do very, very well, but could also lose a substantial portion of the investment.

The best would obviously be to have these risky stocks go up huge in a tax-advantaged account, since I could then sell to diversify and retain all the capital gains. However, should the stock fail, that amount I lost is now permanently gone from the IRA and can never be replaced. For that reason I keep my smaller but riskier assets in a taxable account.

4 Responses

Tks for sharing your thoughts about your asset allocation strategy. I’m still in my research stage about dividend investing so will keep the questions coming as I have them.
Keep up the good work and I look forward to your future postings.

A follow up question to question above is that while we wait for the “right” entry point for any dividend paying stock, I’d like to park the cash to some “better” yielding ETFs and invest when the time is right.

I see that you have a PGX high dividend preferred ETF in your your portfolio but currently have no funds in it, what is your thought on these type of high dividend paying preferred share ETFs? I know these are likely subject to high interest rate sensitivity so if Fed were to hike/lower rates, the fund will be affected positive or negatively… Any thought on where else to get a acceptable yield for unused cash?

Just saw your question now. Busy with work and Memorial Day stuff. I picked PGX for exactly that reason…a place to park cash that is relatively stable with a good yield. PGX is especially nice in that it is is commission free (for Schwab clients and maybe others), relatively inexpensive ($15/share), and pays dividends monthly.

I don’t currently have anything in it because I might need the excess cash for some upcoming bills. In general, as interest rates rise, yields will fall. This will affect it and other preferred ETFs/stocks more negatively than positively. But how negatively, no one knows. Since I’m using it as a short term vehicle for cash not currently invested, I feel that the approximately 0.5% yield that I get per month is worth it. I’ll be in and out of it so often that the grand macro picture is (hopefully) less of an issue.

Other options like Lending Club pay a good interest rate as well but the money is tied up for a minimum of three years. You get interest plus principal back each month though so it can provide a good safety net to provide monthly income. Also, there’s a secondary market for selling loans so it is possible to sell the loans before three years.

Otherwise, it is kind of hard to find good yields these days. I can’t believe that it wasn’t that long ago when checking accounts were paying 3.5%!